Understanding Concentration Risk

If you’re a casual financial news consumer you’ve probably heard the term “concentration risk” before. While it’s easy to assume it’s a term reserved for financial experts, it’s actually a situation with implications that reach far beyond the walls of boardrooms and banks. 

At its most basic, “concentration risk” refers to having a significant sum of money concentrated in one bank. So, if your organization’s deposits are all placed with one bank, your funds may be at risk, particularly if those funds exceed the $250k per tax ID per account covered by the FDIC.

If all of an organization’s funds are consolidated in one institution, then those funds are only as safe as the institution itself. Maybe you can already see where this is going, but if you’re wondering how funds wind up concentrated in one institution to begin with, and what to do to prevent it, you’ll want to read on. 

How & Why Funds Become Concentrated

Several factors can contribute to the concentration of funds in a single bank:

  • Convenience: Deposit concentration can stem from the convenience of existing banking relationships. Individuals and businesses may favor a particular bank due to its proximity, accessibility, or longstanding relationship. Before you know it, all your eggs are in one basket. Convenient? Sure. The safest strategy? Unfortunately, no..
  • Deposit Requirements: Some banks require companies or individuals taking out a loan to keep their deposits at that bank as a condition of the loan. For instance, a company with a $10 million loan from a bank may be required to keep a certain percentage of the loan with that bank in deposits. That helps the bank’s liquidity, but it also can expose a depositor to the risk that comes from having unsecured funds.
  • Incentives and Rewards: Banks may offer incentives, such as higher interest rates or rewards programs, to attract deposits, enticing customers to consolidate their funds in one institution. Those rewards may be attractive, but they come at the expense of a diversified deposit strategy.
  • Loyalty and Trust: Trust plays a pivotal role in banking relationships. Depositors may feel loyalty to a bank they perceive as trustworthy, leading them to concentrate their funds to simplify financial management and streamline banking transactions.
  • Limited Awareness: Some depositors may be unaware of the risks associated with concentration or may underestimate the likelihood of adverse events, such as bank failures or financial crises. (If you know anyone in this category please share this blog post with them.)

The Dangers of Concentration Risk

While concentration may offer short-term conveniences and benefits, it exposes depositors to various risks and vulnerabilities, and one of the biggest risks out there is bank failure.

In the event of a bank failure, depositors with concentrated funds face the risk of losing a significant portion of their cash, since deposit insurance has limits that may fall short of covering their entire balance. For the average individual that might not be an issue, but for businesses and organizations who must manage large sums of money, that lack of deposit insurance coverage can be a devastating loss.

Another pitfall has to do with liquidity. Concentrated funds may become illiquid during periods of financial distress, which makes accessing their funds a challenge for depositors, particularly if the bank imposes withdrawal restrictions. Imagine your organization not having access to its deposits when they need them simply because they happen to be placed with one entity and all the headaches that situation could cause. 

What’s more, concentration risk amplifies the impact of operational disruptions, too. In the event of system outages or cyberattacks, depositors may find themselves unable to conduct transactions or access essential banking services. With no alternative financial partner to rely on, organizations would be stuck having to wait out a solution that they have no control over.

Finally, by limiting exposure to a single institution, depositors may miss out on opportunities for higher returns, better terms, or superior service offerings available from other banks or financial providers. In other words, you could be leaving money on the table and not even know it.

Mitigating Concentration Risk

The good news for depositors is that mitigating concentration risk is relatively simple. Here are a few things to keep in mind if your funds are currently at risk or if you want to take proactive preventive steps.

Diversification: Spread funds across multiple banks or financial institutions to reduce reliance on any single entity and mitigate the impact of a potential failure. Ampersand does this for our clients by leveraging our powerful proprietary software to find the right financial partners for our clients’ needs and placing their funds among our trusted partners in the Ampersand bank network.

Due Diligence: Conduct thorough research and due diligence to assess the safety and soundness of a bank before entrusting it with deposits. The financial services experts at Ampersand are able to take this task off of our clients hands thanks to our decades-long relationships with banking partners and stringent vetting process.

Monitoring and Review: Regularly review banking relationships and reassess concentration levels to ensure alignment with risk tolerance and changing financial circumstances. This is a best practice that we handle for our clients as a matter of routine to ensure their funds are serving their organization’s goals and needs.

Use Deposit Insurance: Take advantage of FDIC insurance offered by banks to protect eligible deposits against bank failures up to specified limits. Diversification can help with this by keeping the amount of money placed with any one institution within those specified limits ($250k per tax id per account for FDIC coverage, for example).

Seek Professional Advice: Consult with financial advisors or deposit management experts to gain insights into effective risk management strategies and tailor solutions to individual financial objectives and constraints. It’s what Ampersand’s pros are here for and it’s what we’re most passionate about — helping businesses and organizations safeguard and grow their funds.

Learn how Ampersand can help your organization avoid unnecessary concentration risk. Contact Ampersand to get started.